External Member of the Monetary Policy Committee Bank of England
MIT Sloan School of Management Professor
Former White House Council of Economic Advisors
For the Bank of England there's one very clear mandate and that's inflation. How will what we do affect the rate at which prices go up? That is front and center in everything we think about.
Interview by Heidi Legg
When we set out to find a visionary and thinker in the financial sector to add to our collection of interviews, Kristin Forbes' name was suggested to us by other economists, as well as from other women her age in finance, the arts and by those equally formally educated, who have opted to stay at home and raise kids. It was one of the first times that such a varied range of people suggested someone to us.
We began to research her. We were intrigued that the Bank of England had selected this American economist to join their Monetary Policy Committee as one of two external members. And we were curious about hearing from someone who was in the White House during President Bush's years, a controversial President, and who watched the collapse of the financial markets that has brought forth finger pointing and reform. But what interested us most was that this MIT Professor was one of the earliest thinkers to focus on financial contagions. I sat down with Kristin to discuss contagions, the current thinking on energy, inflation and economic growth.
What's your most important work goal right now?
Understanding the structure, potential, and limitations of the UK economy in order to set monetary policy appropriately. The last decade has been unprecedented—from an unsustainable boom to a major global crisis, to a very prolonged recovery, to continual challenges in the Euro Zone. At the Bank of England, our mandate is to set monetary policy so that inflation settles around two percent. But to do that, we need to understand how many people can be working and how quickly the economy can be growing without prices going up too rapidly.
And even more difficult, since monetary policy takes about one to two years to be fully effective, we not only need to understand the economy today, but predict where it will be in the future. It is extremely challenging to know what “normal” is after the tumultuous last decade.
What metrics do you employ to ascertain normal?
We look at things such as how many people are working, how many people are looking for work, how many hours they are working, and if there are people who are “discouraged” and have given up even looking for work. We also look at what people are getting paid. Even though people in both the US and the United Kingdom are now starting to find work again, are wages going up?
The unemployment rate has fallen rapidly in both countries, but wages have not been increasing as normally occurs at this point in a recovery. We want to see some normalization where people begin to see their wages go up and make more money over time.
For the Bank of England there's one very clear mandate and that's inflation. We aim to keep inflation around 2 per cent over the medium term. How will what we do affect the rate at which prices go up? That is front and center in everything we think about.
Do you see a scenario where inflation could climb very quickly?
No--at least not in the next few months, I don’t see it. Even though the UK economy is recovering very quickly and it's looking fairly strong. Inflation will not spike up largely because of the recent falls in oil prices and food prices. Oil prices have fallen about 40 per cent and that's going to keep price pressures down quite a bit. It gives us a window to evaluate the strength of economy and when the right time is to raise interest rates.
Can oil prices be predicted? They seem arbitrary.
No. We don't even try to predict oil prices. We take market curves, although we do spend a lot of time thinking about the risks around these curves. What if they go up? What if they go down? What’s worried us quite a bit about oil prices is the turmoil in the Middle East. There are so many geopolitical risks. One could play out numerous scenarios where violence erupts in one of the major oil producing countries, causing oil prices to suddenly spike. Although given the recent declines in oil prices, this would be more manageable today than even a few months ago. That's a risk were very cautious about and watching closely.
Do you think renewable energy will ever overtake oil? Is that a consideration on your radar?
Some of that will be determined by what happens to oil prices. One effect of oil prices being so high over the last few years is that this encouraged companies and consumers to seek alternative energy sources. But if oil prices stay at the low levels we’re seeing today, this might discourage some of the efforts to develop and use alternative energy sources, despite the potential long-term benefits to the environment.
Is that why they've made oil so cheap?
No. We’ve done a lot of analysis, as you might guess, and there are a couple reasons oil is so cheap. One is global growth has slowed, especially in Asia. China in particular was a major oil consumer and their demand was an important driver behind the past price increase. Slower growth in China contributes to lower prices. But that explains only a small portion of the price decrease. Most important has been the big increase in supply, much of which is due to the development of shale gas in the US.
When prices are high, companies invest in new sources of energy, like shale in the US. Once they’ve invested in specific wells, it often makes economic sense to keep producing at those sites for a period, even when oil prices fall back down. Therefore, the past expansion in oil supply may continue to weigh on prices for some time.
Do you believe that inflation is inevitable?
Low inflation is healthy and part of the normal functioning of an economy. Inflation that is substantially higher can make it harder for businesses to operate and individuals to plan for the future. Inflation that is substantially lower, and especially deflation when prices are falling, can be even more of a problem. If items next year are expected to be cheaper than this year, this can cause people to stop buying today. Falling prices can also make it harder to pay back debt. Therefore, low and moderate inflation that avoids these problems is not a bad thing.
No level of inflation (or deflation), however, is inevitable. Some price changes are hard to affect (such as changes in oil prices), but central banks also play a critically important role in helping steer inflation to the level that they think is healthy for the country.
Do you believe that inflation can be controlled? If so, how and by whom?
It is impossible to control some components of inflation. For example, changes in oil and food prices can have large effects on overall prices and inflation. Food prices can be affected by weather, and oil prices can be very volatile (as we’ve seen recently). But central banks play an important role in responding to all of these influences and helping steer inflation to a healthy level.
Central banks primarily steer prices by influencing interest rates. By adjusting interest rates, central banks can adjust the amount of economic activity in a country and therefore the prices people and companies are willing to pay. Central bank policies, however, usually affect inflation with a substantial lag, taking over a year to be fully effective, so central banks have less ability to affect inflation over short time horizons and aim to reach their inflation targets over a “medium term”.
In a global economy, who wins and who loses from inflation?
Low rates of inflation tend to generate stronger and more stable growth in countries around the world. Individuals and companies can better plan for the future when they know where prices will be. Any time that inflation moves by a large amount, either up or down, it can increase uncertainty about the future. This can cause individuals and companies to delay making big purchases or investing or hiring, which is detrimental to the whole economy.
Here are two more concrete examples of the challenges of very high and very low rates of inflation. High rates of inflation can be particularly problematic for middle-income individuals who do not know how to protect their savings against high inflation. High rates of inflation can basically wipe out the value of their hard-earned savings in their bank accounts, leaving them with little money later in life. In contrast, deflation—when prices are falling—can make it harder for people to pay back borrowing. If prices and wages are not going up or even falling, but the interest people need to pay on their borrowing is staying constant, it gets harder to keep up with your mortgages and debt.
It is an important role for central banks to help keep inflation in the “sweet spot” to help support all parts of the economy.
How will the EU respond to Germany's conservative financial ways?
One major difference I've noticed working in the United Kingdom relative to the US is how closely linked the United Kingdom is to the Euro Zone. What happens in the Euro Zone unfortunately has major repercussions for the UK. Back to this idea of contagion, even when the UK has its fundamentals in order and should be doing well, if the Euro Zone goes through another crisis, it affects the UK. Forty per cent of UK exports go to the Euro Zone, and given its prolonged recession, this has meant a reduction in UK exports. That's one reason that the UK's really struggled to recover over the past few years.
Why did finance attract you?
When I was in college, I loved economics. It forced you to think about tradeoffs, cost, and benefits. I found it a very convenient way to think about a whole host of issues.
You went to an investment bank after college and then the World Bank. Why did you leave those pay checks?
Initially, what really attracted me to investment banking was that it kept the doors open. You could go into investment banking and learn about finance and then you could be a banker, or you could go to law school, or go to business school, or get a Ph.D. It also gave me an opportunity to learn the language and tools of finance, which has been immensely helpful. It was a useful education and allowed me to pay off some of my debts.
But I very quickly realized that I wasn't as passionate about banking as others. There were colleagues who would rush in to see their deal in The Wall Street Journal, but I found I'd rush in and prefer to read the Financial Times to see what was happening in Africa with aid programs. This experience reinforced my excitement about economics and so I went to work at the World Bank.
While there, I became very excited about a project that was called the East Asian Miracle. It was a major project in which several groups at the Bank were doing a detailed study on why Asian countries had been able to grow so quickly, lifting millions of people out of poverty, and becoming successful countries over a fairly brief period. What was the magic? What was the trick? And at that time, we didn't really have a great understanding. After World War II, many people had completely missed this potential in Korea, Malaysia, and other smaller Asian countries. There were quotes from an old World Bank study saying, 'they're a basket case. There is no hope in that part of the world. Africa is the potential. Africa has these great natural resources. That's the future.' They got it completely wrong!
In this project, we tried to figure out what worked in Asia, and then what lessons could be applied to countries in Latin America to help them grow and develop and lift hundreds of millions of people out of poverty. I knew that to do that type of analysis and do it well, you needed a Ph.D.
Your MIT thesis focused on 'financial contagion'. Can you explain that term?
The term in finance is similar to the one in healthcare: when something bad happens in one country and it spreads and affects other countries. Except with financial contagion, we focus on the spread of financial or economic problems. Even if some countries have fairly strong economies, they can still be affected by weakness in another country, just as a relatively healthy person can be infected by a sick neighbor.
I was a PhD student during the Asian crisis. The term 'contagion' wasn't even used at that time to talk about the spread of crises. When Thailand's currency collapsed, people did not expect major implications for other countries. But then the crisis quickly spread to Malaysia, Indonesia and the Philippines, and then affected Hong Kong and bigger countries. Some could even say that was the initial part of the domino chain that eventually led to the currency crisis in Russia and then collapse of Long Term Capital Management (LTCM – a hedge fund founded by renowned Salomon Brothers bond trader John Meriwether), which then spread to developed countries. The way in which an event in Thailand spread around the world and took so many people by surprise is what got me excited about better understanding contagion.
Can countries vaccinate themselves?
There are steps countries can take to protect themselves, such as how you structure your debt and your borrowing. For example, structuring debt to have less short term funding, which can suddenly disappear and then plunge you into a crisis, can help. Another important step is to strengthen your banks, so that if banks get into trouble, they will not create risks for the economy. These types of steps are like a vaccine that can block certain types of diseases, although not all. In many cases, even if these “vaccines” can’t completely stop a country from catching a disease, they can prevent them from getting as sick.
What short term funding should be avoided?
One issue for emerging markets, although not as much a problem for the US or UK, is reliance on short-term funding in US dollars. During a crisis, it can be more difficult to borrow in dollars, and especially to repay in dollars if the country’s currency loses value.
What about in the US?
During the recent crisis, we learned that one vulnerability is if banks rely heavily on very short-term overnight borrowing in repurchase agreement (repo) markets or from money market funds. In the fall of 2008, the money market funds and the repo markets dried up, and banks only had limited access to this type of funding.
One role of institutions, like the Bank of England, is to try to ensure that if those institutions do get into trouble, that they fail on their own, without bringing down the rest of the country, or bringing down the banks, or causing widespread contagion or collapse.
How did it feel to be appointed to the White House?
My position in the White House on the Council of Economic Advisors was incredibly exciting, albeit at times stressful. How to describe it…it sounds cheesy but you really feel as if you are working to make the country a better place. You work with many people who make tremendous sacrifices in their personal lives to try to improve the country. It’s inspiring. To even call it work doesn't quite feel right.
Are you proud of the work you did under the George W. Bush Administration?
Yes. I know every president is controversial, but I felt that I could make a positive difference on a number of issues. One aspect that helped is that it is a fairly independent position. You're supposed to provide expert unbiased economic advice to the President as a member of the Council of Economic Advisors. You're not part of the political machine. You're not part of a campaign. You're not supposed to just reinforce political ideals. The position is truly a private advisor who will express his or her views.
As a professor from MIT on leave to do this position, I was even comfortable arguing with the President if I disagreed. Knowing I had a wonderful position to which I could go back made me more confident to stand by my views. I wasn't worried if I made someone upset and lost my job. This gave me a tremendous amount of independence to really stand up and fight for things that I thought were important.
What's an example of something you fought for?
One thing I really fought for was when China was starting to play a much bigger role in the global trading system. There was beginning to be substantial concern about 'the rise of China' and that China was going to take US jobs and that our companies would not be able to compete. A movement began in the administration to really bash China, to negotiate very toughly, and potentially risk a trade war that could have escalated quickly.
I provided a substantial amount of economic analysis to show how Americans were actually benefiting from trading with China, and that some of the proposals would hurt the United States. I had numerous pages and briefings explaining the economics of why an economically strong China was actually in the interest of America and the world. Certainly some people's jobs were at risk, and we needed to do a better job at helping people who lost their jobs find new ones. But even more jobs were being created because of a growing economy and growing exports. People’s wages could buy more due to cheap imports, and the biggest savings were at stores such as Wal-Mart (which imports a lot from China), thereby disproportionately benefiting the lower income consumers who shop there more often. The fact that cheap imports from China actually raise people's living standards overall had been lost in many of the arguments. My briefings with the Cabinet, the President and the Vice-President helped build a different approach to China.
Were they open minded?
I was always very impressed, internally, with the level of discussion and debate. Internally we were encouraged to argue, disagree and not hold back. Even the President and Vice President would ask tough questions and they wanted candid answers. As a member of the Council of Economic Advisors, we were never asked to defend something if that wasn't what we believed in. But it was also understood that we would not go out and publicly disagree, repeat private conversations, or create dissent. Once a policy decision was made, there were guidelines on what you could talk about publically. You didn't air the internal disagreements and debates externally. That may sound difficult, but without those norms, we wouldn’t have been able to have the candid internal discussions and debates that are so important to make good policy decisions.
Is it different in the UK?
I'm in a very different role. I'm focused on monetary policy and the Bank of England is officially independent. We also have incredibly honest debates. There are four of us who are external members of the Monetary Policy Committee and five internal members. The four of us are specifically brought in to challenge the “internals” and make sure they do not get caught up in groupthink.
We have a lot of very candid internal debates and we can have very different views. Over half of the time since this Committee was created, there's been at least one dissenting vote. On a few occasions the Governor, who chairs the committee, has been outvoted. We are encouraged to go out and explain publically why you dissented (or agreed). It is a role that we take very seriously.
Did you see the 2008 financial crisis coming?
A lot of people will tell you they did—but I’d be skeptical of those claims. I saw certain vulnerabilities—as did many economists. There were fractures and fault lines that didn't make sense. For example, I wrote an article in 2006 talking about pricing in emerging markets and lack of pricing of risk that didn't make sense. But could I unwind those fault lines I saw to then predict what played out next? Definitely not.
Have enough limits been put on the US stock markets?
We’ve made a number of important steps in banking reform. I think it's a safer system than it was before the crisis, but have we got it all right? I doubt it. It's going to be a learning process and that's part of the reason why I was excited to work with the Bank of England. They are leading the world in thinking through ‘macroprudential policy.’ How do we efficiently regulate the financial system? You have to think about how all the banks are connected and how they're connected to hedge funds and mutual funds and pension funds and how problems in one could spill over and infect others. How can you make this system safer, but still maintain its efficiency and allow markets to work? The Bank of England is really leading the charge.
Why isn't the US leading this?
The US is doing a lot, also. The Bank of England has a unique structure among central banks, which allows it to be at the forefront and is also part of why I’m there. It has one committee—the Monetary Policy Committee (or MPC)—, which has a mandate to keep medium-term inflation around 2 per cent. A second committee—the Financial Policy Committee (or FPC)—has a mandate to support financial stability in the economy. I am on the Monetary Policy Committee and therefore focus on inflation. While we also consider financial stability issues, it is very useful to have another committee that is the first-line of defense against these types of financial risks so that we can focus primarily on monetary policy.
One lesson we learned from the 2000’s is that interest rates and monetary policy are not good tools to address financial stability concerns, such as in housing markets and subprime mortgages. The Bank of England is at the forefront of central banks in creating this structure with the two committees with different mandates to hopefully avoid a repeat of these types of problems. I would not be surprised if other countries in the world follow this model in the future, possibly even the U.S. Federal Reserve Board. But it is early days, and we will need to first learn how to make this structure work and what tools can best support financial stability. Part of the reason why I accepted this position is that I was excited to be part of an organization that could be helping establish best practices for central banks around the world. But only if we succeed!
How do you move through stressful times?
My favorite is to go hiking, to go into the woods and leave the cell phone and climb a tall mountain. And if I don’t have time for that, I go for a long run with U2 on the headphones.
Did you have a mentor that made a big impact on you?
Yes, Rudi Dornbusch who was a professor at MIT. Unfortunately, he's not with us anymore but he's the one who inspired me that economics can really make a difference in millions of people's lives. More than anything he inspired me, and many economists, to not just write academic papers in an ivory tower, but also apply it to policy and try to affect the real world. He was an amazing, amazing example and too rare, unfortunately, for professors at top universities.
What public opinion do you want to change?
I would like the public to have a better understanding of economics and finance. Too often the public discourse is short one-liners. It's easy to bash the banks, or to bash the finance industry or to bash China. There are often valid concerns and issues that should be addressed. But instead of having a real discussion, many public speakers stick to simple lines to garner attention but misrepresent the issues. People don't understand the importance of many economic issues for their lives.
Today, some might argue finance is so complicated.
…And even if you have a PhD in economics! Many academics are so segregated by their silos of expertise today that it's sometimes hard for leading academics in one field of economics to understand those in other areas.
Some of that is, honestly, the fault of the profession. We focus on tiny little niches in which you go deep to build your expertise, and then you lose the ability to talk about it in layman’s terms. The profession does not reward tenure for being a generalist or being a good communicator.
But also, the financial models seem more complicated.
It is complicated, but exciting. We're in an interim phase. We thought we had models of financial markets, but the crisis showed that we're missing a lot. Now we’re trying to build new models and better understand how the world works.
The world is much more connected than in the past and that has complicated finance. But so is astrophysics, incredibly complicated, but some astrophysicists can still explain the concepts to the rest of us. We also need to do a much better job of explaining economics in terms that you don't need a PhD to understand.
How do you get your news?
If I have the luxury of waking up in my home and getting the newspaper, I love to still open a newspaper. But the reality is I'm usually somewhere else and on my iPad.
Financial Times, daily, and the Economist is the Thursday evening and Friday read. Wall Street Journal. New York Times. Washington Post. The classics. And then there's a bunch of others I flip through.
No. I worry that now people are always interrupted by things like Twitter or email so that it's very hard to sit down and actually read or think or write anything deeper. I see this in my students. What I assign for reading today is a fraction of what I used to assign, and they still complain that they can’t get through the readings. I think our minds are getting trained so that we don't sit and read and think the way we used to. I worry that people are dedicating too much energy to writing short little blurbs and we are losing the more useful analysis. This seems especially true in my field. I purposely stay away from Twitter and blogs so that I have more time to think and delve into issues more deeply.
An event you're looking forward to next year?
The non-PC answer? I am really looking forward to the two weeks in August when my two jobs will both be on vacation at the same time.
In Boston, The Charles River for running.
In London, I purposely will walk out of my way to pass by the Tower of London. There is something about the history of that place that's fascinating and puts your short time on this earth in context. Also, the poppy display (red porcelain poppies planted in honor of soldiers killed in World War I) was stunning. The white walls of the Tower surrounded by the red poppies over the fields was just breathtaking. Somehow walking by that always brought me some serenity.
How do you manage with a family, young children and two cities and two jobs?
MIT has been fantastic in helping me work my teaching around my commitments to the Bank of England. I commute between Boston and London on most weeks. When I am teaching at MIT, I generally do intense executive courses or specialized courses for a couple of days straight and then can spend intense periods working on monetary policy. And of course I couldn’t do it without my fantastic wingman (my husband)!